Best Practices for ETF Trading
The process of purchasing or selling shares of an ETF is different from a mutual fund because an ETF is listed on an exchange, trading similar to a stock. As such, there are several industry best practices and nuances for investors to consider when trading an ETF, covering areas like:
- Choosing an Order Type
- The Timing of a Trade
- Nuances for International Markets
- Secondary & Primary Market Liquidity
- Executing Large Trades
In this piece, we will dive into more details on each of these topics to assist investors with general ETF trading best practices and education.
Choosing an order type: managing risk with limit orders
Limit Orders guarantee a specific price or better, but not execution, while conversely Market Orders assure an execution, but not a specific price. For some ETFs, secondary market liquidity (“onscreen liquidity”) can be thin, meaning few shares of the ETF are traded on exchanges and market makers are not offering much depth (available shares) around the Bid or the Ask price. The risk of placing a Market Order in this situation is that an investor could inadvertently ‘sweep the book’ by buying more shares than are available at a given price, leading to poor execution prices far away from the original bid or ask. Therefore, investors can avoid this situation by using Limit Orders when trading ETFs.
The timing of a trade: turbulence during market open and close
The market for ETFs can take time to develop on a given day. For this reason, avoiding trading ETFs too close to the market open or close may help avoid poor price execution and volatility.
Nuances of international markets: considerations for long local market closures
A US-listed ETF may hold securities overseas that trade during different time zones or are closed for local holidays. While not always possible, trading an international ETF while the local market is open generally leads to better executions.
It’s important to remember that if the local market is closed, the IOPV (Indicative Optimized Portfolio Value) and NAV (Net Asset Value) for the ETF could be stale. This is because IOPVs and NAVs are typically calculated based on the last traded price of the ETF’s underlying holdings. If the local market is on an extended holiday, these prices could be multiple days old. Therefore in these instances, the current bid-ask spread for the ETF is likely a better indicator of the market’s current value of the ETF rather than the IOPV or NAV. For example, during the 2019 Lunar New Year in China, the Hong Kong Stock Exchange will close for three consecutive business days. During this holiday, the bid-ask of a China-focused fund, like the Global X China Consumer ETF (CHIQ), is likely a better indication of the market’s real-time value of the Fund than its IOPV.
Secondary vs. primary market liquidity: two different sources of liquidity
Investors executing smaller ETF trades use the secondary market, a stock exchange, to buy and sell shares. Secondary market liquidity, also known as ‘onscreen liquidity’, can be influenced by many factors such as how many market participants are quoting and trading shares of an ETF on exchanges, as well as the fund’s underlying liquidity, discussed below.
Primary market trading is restricted to authorized participants (APs) who are able to transact with an ETF manager to create or redeem shares of the ETF. Primary market liquidity is not influenced by the trading volume of the ETF itself, but rather by the liquidity of the underlying holdings of an ETF. For example, a broad US large cap ETF will almost always have more primary market liquidity than a small cap emerging market ETF. Some data providers, like Bloomberg, provide more insights into this underlying liquidity, but not all investors have access to this data. This is why it can make sense to contact your broker or a specialized ETF trading desk when considering to execute trades, instead of just looking at onscreen liquidity.
Executing large trades: primary market is a better representation of ‘true’ liquidity
If executing a larger trade (generally hundreds of thousands of dollars, if not millions), it may be worth contacting your broker, a specialized ETF trade desk, or a market maker. They may be APs themselves or work regularly with APs to create or redeem shares, which could result in better execution than just trading in the secondary market. Block trades occur at an agreed upon price, instead of allowing market impact to possibly fluctuate as the order is filled. With less liquid ETFs, traders may need to work the trade over the course of a day, which could introduce the risk of price fluctuation.